Problem of sample heterogeneity

The econometric studies that support the dominant discourse on the relationship

between institutions and economic development assume, without much critical reflection, that the same relationship holds across countries. Insofar as the problem is recognized, dummy variables, especially ‘regional’ dummy variables (e.g., African dummy) are used to partly deal with it, but this is essentially an atheoretical approach. However, if the relationship differs across countries, it means, in statistical terms, that the ‘homogeneity condition’ is violated. This makes the parameters unstable and thereby the results sensitive to the sample.

I have already talked about the example of IPR institutions, whose relationship with economic growth differs across rich and poor countries. For another example, an independent central bank may be good for countries that specialize in finance, as it would ensure that the interests of finance are put before those of other sectors in the economy (e.g., maintenance of a strong currency, tough attitude towards inflation, and, in case it also has regulatory power, a more lenient approach to financial regulation). In contrast, an independent central bank may not be good for other countries, especially the developing ones that need aggressive investments and therefore a more relaxed approach to inflation, on the one hand, and a tougher financial regulation, given that their thin financial markets may be more easily manipulated, on the other hand. Of course, violation of the homogeneity condition is a common problem with all cross-section studies, and not just the ones looking at the relationship between institutions and growth, but the problem may be more acute in the case of the latter studies. The relationship, as pointed out above, is much more complex and more poorly understood than other economic relationships, so the likelihood of heterogeneity in the sample is even greater in this case.

Back to theories – theories of institutional change

When institutional deficiency was identified as the key explanation – or at least one of the key explanations – for the puzzle of ‘good’ (liberalization) policies failing to work, the supporters of such policies could actually have taken two courses of action.

One course of action, which was not taken, would have been to recognize that their policies work well in economies that have liberalized institutions (which itself is a doubtful proposition, but let us give it the benefit of doubt for the moment) but not in economies without those institutions. Then they could have given up implementing their preferred universal policies and proceeded to prescribe to each country only policies that had been designed with its institutional characteristics in mind. This course of action, unfortunately, was not taken.

The course of action taken was to change the institutions, rather than the policies, in line with the so-called GSIs. So, for example, it was argued that deregulation has failed to work in many countries not because it was a wrong policy but because private property rights were weakly protected in those countries, thereby failing to assure potential investors that they will reap the full gains from their investments. In such a case, it was argued, the right thing to do would be to strengthen the protection of property rights, rather than backtrack on deregulation. Likewise, from this perspective, privatization could be seen to have failed to deliver the expected results not because private ownership does not work in the particular cases in question but because the privatized corporations were not well governed due to poor legal institutions, especially the weak protection of shareholder rights. Once again, the right response would be to improve the corporate governance institutions and then push further with privatization, rather than reversing or stopping privatization.

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